Two in-depth studies of the investment practices of sovereign wealth funds (SWFs) have revealed the delicate nature of balancing long-term and short-term objectives, and a leaning towards more illiquid assets.

Conducted by one of the International Forum of Sovereign Wealth Funds’ research partners, State Street, both papers used existing academic literature, interviews with academic experts and IFSWF members to collect their findings.

Asset allocation for the short and long term, a survey of 10 SWFs focusing on asset allocation – both current allocations and the evolution of allocations – showed that they tend to allocate to more traditional investment categories, and are more heavily weighted to fixed income than equity.

The funds’ investments were primarily focused in foreign markets (about three quarters of assets) and were predominantly focused on the developed world, rather than emerging markets.

However 50 per cent of respondents said they had increased their allocation to emerging markets over the past three to five years. Other asset classes to benefit from increased allocations by SWFs in the recent past include infrastructure, real estate, and hedge funds.

In the future, around 20 per cent of respondents said they would increase allocations to equities, infrastructure, real estate, non-listed, and emerging markets.

Actively managed investments were favoured over passive by only a small margin of respondents (54 to 46 per cent), and listed outweighed non-listed by three to one.

The paper explored how SWFs, as long-term investors, evaluate asset classes and asset managers, and how diversification and risk can be measured as a long horizon investor.

Will Kinlaw, senior vice president at State Street and one of the papers’ co-authors, said one of the concepts explored in the asset allocation paper was how diversification plays out over different time horizons.

“For example in emerging markets, if you are using monthly data, the correlation between emerging markets and the US is very high. But if you use three-year time periods then it’s a much lower correlation, near zero,” he says.

“This means you can’t just rely on simple metrics, especially in alternatives. There is a blend of qualitative and quantitative analysis that needs to go into it. It’s important in examining diversification and correlations to look over different intervals. What drives risk over different periods varies; for example over a long-term period it’s driven by earnings, over shorter time it’s discount rates.”

In terms of the SWF’s opinions of the most relevant competencies required in expanding to new assets classes, an overarching theme, apart from the obvious need for analytical aptitude and commercial acumen, was the importance of being able to build and maintain relationships.

Whether it was with regard to building internal capacity through cooperation with outside resources, through establishing relationships with consultants/advisors, or through establishing communication channels with external managers, the key competency mentioned revolved around relationship building. This has important implications for identifying external investment resources, for hiring investment talent, and for establishing and maintaining a collaborative culture within investment teams.

The asset allocation survey also looked at the challenges faced by SWFs in investing in private markets, which included lack of transparency, illiquidity, lack of appropriate benchmarks, fees and insufficient in-house resources.

The respondents thought the keys to success in private market investing were:

Investment and operational due diligence process.

Institutional relationships and manager alignment.

In-house resources and human resources policies.

Governance structure and stakeholder communication.

Speed of decision making.

Sophistication of risk management systems.

Size of assets under management.

 

Overcoming challenges in private markets

A separate study that looked at how SWFs are addressing the challenges of private market investing, Comparison of members’ experiences investing in public versus private markets, found that the primary driver for investing in private markets, by the SWFs interviewed, was the potential for a return premium.

Some SWFs stated that they were well suited to bear illiquidity risk due to their long time horizon. But, even where private market investments have performed well, internal debates continue as to whether the premium compensates fully for the illiquidity and other risks associated with private markets investing.

“Illiquidity is the biggest risk of investing in private markets even if these investors have long horizons, because illiquidity is the opportunity cost; it’s what you give up for that premium, you can’t just assume illiquidity premiums are priced in,” Kinlaw says.

In addition to a return premium, the SWFs said private markets offered access to specific exposures, and introduced some beneficial diversification.

The main risks that SWFs needed to manage and mitigate included a concern that investments were too concentrated; a concern about leverage risk; the risk of capital loss; a greater degree of reputational, tax and regulatory risk; currency risk; illiquidity risk; the risk of hiring a bad manager; and key person risk and turnover.

Each of the SWFs spoke at length about the capabilities and governance structures that they had developed in order to launch a private markets program. The importance of people was a major theme, and each of the SWFs said that their commitment to developing a qualified and talented team was a key ingredient to their success.

“The interviews revealed that to be successful the funds have to have good talent, they really focus on it but also struggle with it because many SWFs are in remote locations. The human element is more essential in private investments than public investments,” Kinlaw says.

“Access is also linked to having the right people in house. Private markets are a long-term investment, so it’s tricky to have staff turnover; you want someone around for the long haul.”

Funds also spoke about the need for enhanced governance and decision-making frameworks to balance the complexity of private markets, and the need for due diligence, with the pressure to move decisively when opportunities arise.

The SWFs employed a range of practices to hire, develop and retain strong teams, including developing local staff by co-operating closely with private equity firms, leveraging external consultants to supplement or complement in-house staff, identifying staff with relationships, avoiding silos in the organisational structure, building strong middle and back office teams, building teams with a diverse set of skills, and retaining staff by instilling them with a sense of purpose.

Following the hour-long interviews, the paper produced a list of advice to sovereign wealth funds wanting to invest in private markets:

  • Establish a strategy based on expertise you can build in-house.
  • Start slow. “This was a really emphatic point,” Kinlaw says.
  • Private markets are local markets and require local knowledge. One big advantage is to partner with other SWFs. When the survey asked SWFs if they have co-operated with other SWFs or large investors, 100 per cent said they had.
  • Thorough due diligence.
  • Establish strong governance and decision making, avoid silos and group think.
  • Emphasise qualitative over quantitative factors with managers.
  • Cultivate a long-term horizon and a long-term culture. This includes performance measurement and the way people are compensated.
  • Create ways to build a team and have them be committed.
  • Learn from your success and failures. “Really take the time at the end of the investment to look at the reasons for going into it versus what happened, and institutionalise that learning,” Kinlaw says.

“The investment landscape has evolved significantly in recent years, and SWFs have contended with an ever-expanding array of investment opportunities in both public and private markets,” Roberto Marsella of CDP Equity (a company of the Cassa Depositi and Prestiti group of Italy) and lead of the investment practice committee of IFSWF, says. “In response, many are re-evaluating the methods they employ to construct portfolios and measure and manage portfolio risk. The low interest rate environment creates new challenges and requires reassessment of investment methodologies and professional skills.”

The California Public Employees Retirement System (CalPERS) board meeting was broadcast live from California on Monday, December 19, 2016, presenting an opportunity to watch the body deliberate as to whether it should reverse its tobacco-free investment policy or extend the restrictions to all externally managed funds, which would capture a further US$547 million.

The board decided to maintain and extend the restrictions on tobacco investment. The public health community and politicians lauded this decision, with California state treasurer John Chiang stating, “Today, we not only successfully fought back misguided efforts to lift CalPERS’ 16-year-old ban on direct tobacco investments, but also we ended the system’s inconsistent position of allowing outside partners to quietly make such investment on its behalf.”

A majority of the CalPERS investment committee, consisting of every member of the governing board, supported the motion, with three of the nine directors voting against. The dissenting directors were obviously compelled by the recommendations their staff and external consultants made as they attempted to separate the societal and ethical considerations from the financial (a big ask for the health community).

During the deliberations, Allan Emkin, of the Pension Consulting Alliance, addressed the board. He followed Dr Stanton Glantz, a professor of medicine, director of the University of California, San Francisco Center for Tobacco Control Research and Education, and the author of more than 350 scientific papers.

Emkin said, “There is one agreed principle in the investment community – that diversification manages risk.” He then quickly concluded, “Therefore, divestment reduces opportunity.” The situation seemed clear: diversification is good, divestment is bad, and it’s as simple as that – everyone agrees.

But do they?

This tactic of economists and financiers presenting their positions as universal and uncontestable truths is common. The many assumptions and qualifications that underpin economic theories and investment positions tend to be reduced or omitted completely. This strategy contrasts markedly with the public health and science community, which routinely addresses counter-arguments and explains the rigour behind positions. This variance in approach was evident at the CalPERS meeting, as investment advisers attempted to create a certainty that did not necessarily exist.

There will, of course, always be counter-arguments to any held belief, even if it is considered fact or truth. For example, despite the US Surgeon General declaring in 1964 the link between tobacco and poor health outcomes (based on more than 7000 articles), today British American Tobacco claims the following on its website: “To date, scientists have not been able to identify biological mechanisms that can explain with certainty the statistical findings linking smoking and certain diseases.”

Like almost all issues we face, diversification is not black and white. Emkin claimed that greater diversification reduces risk by definition, with a nod to a classical, Harry Markowitz-style, mean-variance view of the world. This is overly simplistic. In reality, the benefits of diversification may be achieved with relatively few securities. Indeed, diversification for its own sake may contribute nothing in terms of risk mitigation while lowering returns (thus legendary investor Peter Lynch’s neologism ‘diworsification’). Further, Emkin’s presentation offered little discussion of the specific risks of investing in tobacco companies, merely an assertion that their presence in a portfolio would add diversification benefits.

Diversification presents one way to manage risk but not the only way. Analysis of environmental, social and governance factors and investing with a long-term lens, so that prospective risks are not merely acknowledged but truly accounted for, are other ways to reduce risk in an investment portfolio.

There are now plenty of examples of funds that perform well that either enforce exclusions or are considered not diversified. The Responsible Investment Association Australasia went so far as to declare in its 2015 Benchmark Report that “once again … the myth of underperformance of responsible investments is unfounded”.

Those attempting to make a purely financial case against divestment in tobacco tend to oversimplify the situation. They set aside very real risks and considerations in relying on past performance (easier to measure) rather than future expectations (uncertain) and they most often completely ignore the devastating impact of the product.

Divestment is the role the finance community can play in addressing what the World Health Organization calls the “global tobacco epidemic” that will cause the deaths of 6 million people this year. It’s not just about what divestment might achieve in terms of increasing the cost of capital or forcing the industry to fold, it is about joining governments and our health and education sectors as they attempt to de-normalise and stigmatise an industry that has continued to actively encourage new consumers, namely children.

We can debate the certainty of risks and returns, but maintaining that investment in tobacco is in the best interests of ordinary workers is clearly becoming an increasingly difficult position for directors to hold.

We should all hope that a tobacco-free position becomes a certainty.

 

Clare Payne specialises in ethics in banking and finance. She holds the positions of chief operating officer with Tobacco Free Portfolios, initiated – and is now a director of – The Banking and Finance Oath (thebfo.org) and is Fellow for Ethics in Banking and Finance with The Ethics Centre, both in Australia.

Analysing the most read stories of 2016 reveals some interesting trends. Investors are interested in reading about their peers, as our Investor Profiles feature heavily, as do the interviews we have done with CEOs and CIOs of the world’s largest asset owners.

But overwhelmingly the most popular investment stories have been about fees and issues of sustainability – including ESG integration and portfolio de-carbonisation.

In 2016 we have delivered more than 300 investor profiles, analytical and research-driven pieces on the global institutional investment universe.

Below is another look at the 10 most popular stories of 2016.

Thank you to all our interview subjects, readers and supporters over the past year.

New York’s actions louder than words

Creating a low-carbon index was a practical way for the New York State Common Retirement Fund, the third largest pension fund in the United States with $178 billion in assets, to put its beliefs into action.

Vicki Fuller, chief investment officer of the fund, says that environmental, social and governance (ESG) considerations are integral to the investment philosophy of the fund.

“We live by them, they are firmly mentioned in our investment philosophy as a source of return and risk, this is not new for us,” she says.

“It is not new for us to be invested in renewables, solar, wind, and active managers who execute sustainable strategies.”

Now $2 billion of US equities is passively tracked to this low-emission index, which excludes or reduces investments in companies that are large contributors to carbon emissions, like the coal mining industry; and increases investments in companies that are low emitters. Read more

 

SASB the missing link in ESG integration

No longer can analysts use the excuse there is inadequate data for incorporating ESG into investment decisions.

The Sustainability Accounting Standards Board (SASB), a not-for-profit chaired by Michael Bloomberg with Mary Schapiro as vice chair, was formed to set market standards for disclosure of material sustainability information to investors. With “material” defined as likely to affect financial performance.

The organisation – founded by Jean Rogers and made financially viable through donors including Bloomberg Philanthropies; foundations such as Ford, Rockefeller, PwC and Deloitte – is predicated on a belief that ESG factors can impact company financial performance and drive long-term value. The fact there is a now a broader range of risks and resource constraints beyond just access to capital makes the use of standardised financial reporting to investors insufficient.

This means that a new, standardised language is needed to articulate the material, non-financial risks and opportunities facing companies that affect their long-term value creation. Read more

 

Top1000 PRI edition

To commemorate the 10th anniversary of the Principles for Responsible Investing,
Top1000funds.com released a special print edition magazine and was the official publication for the PRI in Person in Singapore in September. Read more

 

HOOPP fully invested in the future

HOOPP, the C$63.9 billion ($50 billion) multi-employer defined benefit plan, is an extraordinary position of being 122 per cent funded. It continues to focus on innovative investments – such as credit derivatives – as a way to achieve its pension promise.

“We view ourselves as a pension delivery organisation, while a lot of other funds see themselves as asset managers. Asset managers generally measure risk in terms of market volatility or drawdown in capital, but our mantra is to deliver on a pension promise,” says Jim Keohane, president and chief executive of Healthcare of Ontario Pension Plan, HOOPP.

“We define risk as based on factors that may impede our ability to write that cheque 25 years from now, which would include additional factors such as changes in the purchasing power of our assets, caused by changes in interest rates and inflation. We don’t benchmark ourselves against returns, we aren’t this type of organisation. Measuring against returns does not give a full picture of whether or not you have succeeded.”

Success, for Keohane who has been at HOOPP since 1999, is better measured by the glowing funded status at HOOPP, up to 122 per cent from 114 per cent in 2014, despite all of last year’s economic uncertainty.

HOOPP is a C$63.9 billion ($50 billion) Canadian fund is a multi-employer defined benefit plan, serving 309,000 working and retired healthcare workers.

Its liability driven investment, LDI, comprises two investment portfolios: a liability hedge portfolio, designed to hedge the major risks that would impact HOOPP’s pension obligations – namely inflation and interest rates – and holding assets which perform in a manner similar to its liabilities, and a return seeking portfolio designed to earn incremental returns and bring diversification benefits. Read more

 

CalPERS chief navigates perfect storm

Outgoing CalPERS’ chief executive Anne Stausboll talks to Amanda White in an exclusive interview discussing her passionate views on sustainability, simplifying the portfolio, and where the improvements are needed.

When Anne Stausboll started her role as chief executive at CalPERS it was a tumultuous environment, or what she calls a “perfect storm”. It was January 2009, the markets were in crisis, there was a state budget crisis in California, and CalPERS was facing ethical issues relating to the fund and former employees.

“My focus was on restoring trust and credibility to the organisation, and making it transparent and open,” she says.

Where historically the culture at CalPERS had been built around its size, and the large size of its portfolio; Stausboll has been focused on rebranding CalPERS around a public service organisation.

“We are here to serve others who have served California,” she says. “This has brought the organisation together, and it is very unifying to brand around that.”

CalPERS is a big business, and the role of CEO is immense. CalPERS administers retirement benefits for more than 1.8 million California public sector workers and oversees an investment portfolio of approximately $300 billion. CalPERS also purchases health care for nearly 1.4 million members.

And this means Stausboll oversees around 2,700 employees and an annual budget of $1.8 billion.

“When I started my job as chief executive in 2009, CalPERS had been here for 75 odd years,” she says. “One thing that struck me about the organisational structure was we didn’t have a financial office. That was quite a gap.”

She sees it as one of her greatest achievements; that there is now a well-established and well-functioning financial office, that also oversees risk management, and is integrated with the actuarial office and investment office. Read more

 

Pay for performance

Pension fund executive pay varies widely around the globe, with differences based on the extent of internal management and alternatives exposures in the fund. So what is best practice for pension fund executive pay?

In 2014, the Ontario Teachers’ Pension Plan (OTPP), considered by many to be the best pension plan organisation in the world, paid salaries, incentives and benefits to its 1109 employees of C$300.5 million.

As chief executive, Ron Mock, got a base salary of C$498,654 and total direct compensation of C$3.78 million – which included long-term incentive payments of C$1.961 million. Neil Petroff, the executive vice president of investments, got paid C$4.48 million, including C$2.722 million of that in long-term incentives.

These sound like grand figures. And indeed they are. However, what is behind the figures is more interesting than the numbers alone.

The total investment costs of OTPP, including staff salaries was C$460 million. On assets of C$153 billion, that’s about 28 basis points.

Conversely, the $295 billion CalPERS, which is restricted in what it can pay staff due to its public sector identity, paid $159.3 million in salaries and wages in 2014 – around US$60 million less than OTPP. But it spent a massive $1.347 billion in external management in the 2014 financial year. Which means it is paying costs of about 45 basis points on external managers alone. Read more

 

A hedge fund performance reality check

Pension funds need investment strategies with attractive risk and return characteristics to fund their liabilities.

Hedge funds are increasingly popular investments which purport to fill this need, as witnessed by a 25-fold increase in hedge fund use in the CEM global database between 2000 and 2014.

But have hedge fund portfolios delivered these benefits? New CEM research indicates that some did but most did not. Read more

 

AIMCOs evolving hedge fund strategy

Canada’s Alberta Investment Management Corporation, (AIMCo), the C$90.2 billion ($69.4 billion) fund that invests on behalf of 26 pension, endowment and government funds, has more than three quarters of its assets in public markets, most managed internally.

This includes money market and fixed income allocations and a diversified mortgage portfolio, but the most sizeable chunk lies in a $27 billion sophisticated equity portfolio that combines passive low cost strategies with complex hedge fund allocations.

Internally managed equity investments include quantitative and passive strategies which currently invest in 45 countries around the world. Smart beta is one such allocation, and with it AIMCo aims to add 100-150 basis points every year.

“It’s been successful. I like smart beta,” says chief investment officer Dale MacMaster, in an interview from the fund’s Edmonton headquarters.

“We want to access beta as cheaply as possible.” Read more

 

Principles for restructuring fund manager fee

The mechanism for sharing risks via fees in the pension industry is weak, according to Fiona Trafford-Walker. Asset-based fees have little linkage with the manager’s ability, clients don’t generally get enough benefit of scale and there is not usually a penalty for underperformance other than termination of the relationship. So how should asset owners pay their managers? Read more

 

Private equity cost disclosure the solution

Investors should adopt the standardised fee reporting template for private equity released by the Institutional Limited Partners Association, according to Mike Heale and Andrea Dang from CEM Benchmarking. Their research shows that it is not possible to get complete costs from current statements alone, with important costs buried by GP’s statements. CEM encourages all pension funds to adopt the ILPA fee reporting template by asking all GPs to report in this format. Read more

 

 

 

The lead author of a major global study into how the motivations of people in the investments industry are linked to their performance has argued that annual bonuses should be dumped.

A staggering 76 per cent of investment professionals surveyed admitted to letting pressure from members of their board and management team negatively affect their decision-making.

And it has them worried; 17 per cent of investment professionals said they believed their job would be at risk after a short period of underperformance.

“What money does to your brain is detrimental,” State Street Center for Applied Research global head Suzanne Duncan says.

Globally, the majority of investors included in the study believed they would be sacked after 18 months of underperformance. This fear of losing their jobs, along with anxiety about earning short-term bonuses, is causing investment managers to behave in dysfunctional ways, she says.

Boston-based Duncan spoke to Top1000Funds.com as she launched the report, titled Discovering Phi: Motivation as the Hidden Variable of Performance, which was compiled by State Street Corporation’s research arm in conjunction with the CFA Institute. The research is based on a survey of roughly 7000 investment professionals in 20 countries.

The authors of the report state that they have developed a method for quantifying an elusive factor they call Phi, which has a positive impact on organisational performance, client satisfaction and employee engagement.

Phi is an acronym for purpose, habit and incentives – as well as a nod to the 21st letter of the Greek alphabet.

The report concluded a one-point increase in Phi was associated with 28 per cent greater odds of excellent organisational performance, 55 per cent greater odds of excellent client satisfaction and 57 per cent greater odds of excellent employee engagement.

Massive disconnect from purpose

To be a successful investment manager, individuals need a high degree of skill and competence, but they also need the right motivations.

“Why we do something influences how well we do it,” Duncan says.

The researchers found that organisations and teams they rated as having a higher Phi score were significantly more likely to deliver superior long-term investment returns. However, only 17 per cent of investment professionals globally had high levels of Phi.

The report’s underlying data shows why.

Phi is a “socially contagious” quality and spreading it “starts with strong leadership”, Duncan explains. “It is a nature and nurture situation. We need to recruit for Phi, we need to foster it, and we need to pay for it.” Yet the survey responses show this is often not happening.

Just 28 per cent of respondents worldwide said they remain in the investment management industry to help clients achieve financial goals. Also, only 44 per cent of professional investors surveyed believed their leaders articulated a compelling vision and just 40 per cent said they believed their leaders re-examined their own critical assumptions and beliefs.

A mere one-third of respondents believed leaders were spending time teaching and coaching employees.

Incentives are all wrong

Duncan says that despite investment professionals being well paid compared with workers in most other sectors, money is the “number one de-motivator” for the industry. This is because pressure to make short-term incentives leads to high stress levels and reduces the motivation to work in a client’s best interests.

Close to half of all investment professionals surveyed globally reported being treated for a medical condition related to work stress in the past year.

“Thinking about making money narrows the thought process and reduces overall thought power,” Duncan says.

She argues that bonuses needed to be re-designed to make sure they are structured in a way that is fair, transparent and controllable. She praised a trend among some Australian super funds to dump annual bonus structures in favour of five-year incentives.

Young and Phi

Worldwide, workers from the millennial generation recorded markedly higher Phi scores than their older colleagues.

Duncan rejected the idea that this merely reflected the idealism of youth, insisting there is “something different” about what motivates those born in the 1980s and 1990s that she tips to persist as they age.

Looking at another age group, Duncan says there seems to be “an inflection point” at age 51, where Phi scores also dramatically increase.

“I think you get to that point in life and realise it’s not all about you,” she says. “Having children has a similar effect on most people, leading to increased empathy and altruistic motivation.”

The report’s conclusions about how altruistic motivations improve investment outcomes fly in the face of the traditional perception that top-performing fund managers are ultra-competitive and hyper-focused on profits.

At the Investment Management Consultants Association annual conference in Sydney, Australia, in November 2016, P/E Investments managing director Australia and New Zealand, Andrew Harrex, said half-jokingly that he suspected there was “a correlation between arseholes and good fund managers”.

“I’d love to see the analysis,” he said. “I suspect there is a correlation, because you have to have a big ego to say ‘I am right and the market is wrong.’ ” In a sense, the new State Street research is analysis that shows exactly the opposite.

Duncan explains: “That type of individual often outperforms on a short-term basis but it is rare that they continue to outperform on a long-term basis, and our research backs that up. Big egos tend to get caught up in their own behavioural bias and a high degree of confidence in oneself can often lead to a failure to sell when you should.”

Social context

While low levels of Phi are a problem across the industry worldwide, investment professionals in Scandinavian countries reported the highest scores, followed by Australia and Canada.

Duncan says this is a reflection of the “welfare state” mentality in these countries.

“The US is the complete opposite of that … It’s a free-for-all where you look after yourself,” she says.

Duncan explains that while Wall Street is unquestionably the global heartland of financial markets, she doesn’t consider her home country a leader when it comes to long-term investment management.

From 2017, State Street will offer the Phi score assessment tool for all of its clients to use internally and with their external providers.

CFA global president Paul Smith says: “Phi is the variable that’s been missing for too long from the investment management ecosystem. The research shows that when there’s a lack of purpose to temper passion, the balance and alignment of interests and motivations becomes distorted.”

Finland’s €18.5 billion ($20 billion) State Pension Fund (VER) will slightly increase its allocation to hedge funds, in a strategy designed to counter the continued challenges low interest rates create for its sizeable fixed-income holdings.

“We have to be careful increasing our allocation to hedge funds, given interest rates are low and hedge fund returns after fees are hard to find,” explains Timo Viherkenttä, chief executive of the Helsinki-based buffer fund. “On the other hand, low interest rates have made hedge funds a competitive alternative to fixed income.

The two allocations can compete with each other in the portfolio because they are both low-volatility asset classes; we don’t expect high returns but we expect roughly zero from fixed income, so hedge funds have a place in the process,” he says.

The fund has a 3 per cent allocation to hedge funds that, together with risk premia strategies, will grow to closer to 6 per cent.

VER is tasked with meeting Finland’s future pension liabilities, which are set to peak in 2030, when state pension expenditure is expected to be nearly double current levels.

The fund’s appetite for more diversified and uncorrelated returns chimes with Viherkenttä’s view on the current, unpredictable, market.

“Right now, we are in a peculiar situation and it’s very unsettled,” he says. “In recent years, investors have looked at central banks for guidance. Now, politics has taken more of centre stage, with Brexit, then the US [election], and now European elections. The traditional real economy is in the back seat. Take, for example, the rise in the equity market after the US election. Optimists pointed to the rise, but there is a lot of wishful thinking because it is just not clear what policy will be.”

Finland’s ministry of finance rules that VER must devote a minimum of 35 per cent to fixed income, in an allocation the fund divides between liquid and other fixed-income investments. VER’s current allocation exceeds this baseline, with just under half the portfolio in the asset class.

Although it has performed well recently, low interest rates and “unpromising pricing levels” don’t bode as well going forward. Five-year average returns on liquid fixed income languish at 3.2 per cent in an allocation comprising government bonds (22.6 per cent) corporate bonds (25.6 per cent) emerging market debt (21 per cent) and money markets (30.8 per cent). The return-seeking allocation includes corporate bonds and emerging market debt, plus illiquid private credit funds.

Viherkenttä is more optimistic about emerging market returns.

“We have a sizeable allocation to emerging markets. It’s well known that this market came down quite a bit after the US election. The pricing there now is better than a few weeks ago. There may be a bit of beef here.”

While most of the private credit portfolio is weighted to low-risk strategies like senior and real-estate debt, it also includes a higher level of risk, such as distressed credit funds.

The remainder of the portfolio lies in listed equities (now about 40 per cent), a new allocation to position management and diversified investments begun a year ago, and alternatives.

Currency hedging and derivative trading, as well as absolute return funds, fall under the position management and diversified umbrella. Alternative investments include property, private equity, infrastructure and private credit allocations.

“We will increase our allocation to illiquids in search of more diversity,” Viherkenttä notes. “Pricing in illiquids is high; many others also have this ‘great idea’.”

The increased allocation to illiquid strategies will focus on infrastructure and real-estate assets for inflation protection. A “sizeable” percentage of investment in these types of assets, along with private equity, tends to have a Finnish bias. All of VER’s real-estate investments are made through funds or indirectly.

Viherkenttä leads an in-house team of 14 and uses more than 100 managers. The fund’s fixed-income allocation is almost entirely actively managed, while half the equity allocation is in passive strategies.

“In some markets, like large-cap US, it is very difficult to find excessive returns,” he says.

Although passive solutions are more developed and competitive in equities than in fixed income, he says the line between active and passive is evolving.

“Take smart beta,” he says. “This may be index and passive, but the basic choice in this strategy is an active concept.”

He explains that fixed income is evolving to make more passive options available to investors.

“In any major fixed-income market, you will find ETF solutions,” he says. “Whether you want to invest in emerging markets or emerging market local currency, or credit, or US high yield, you would find such products, to invest in a passive way. It’s long been the case in equities and it is increasingly so in fixed income, too. There are more specialised solutions – like factor-based strategies – in equities, but they are on their way in fixed income, too.”

Viherkenttä’s career spans academia and law and includes eight years at local authority pension provider Keva as deputy chief executive. Prior to this, he spent four years as budget director at the ministry of finance, and also as permanent under-secretary responsible for tax policy.

“My legal background helps in many ways in this job across administration and legal matters but I identify most with economics,” he concludes.

Brian O’Donnell, executive in residence at celebrated risk management institute, Toronto-based Global Risk Institute, argues that pension funds need to adopt clear risk strategies to deal with cyber security, climate change and escalating financial risk.

In a webinar hosted by the International Centre for Pension Management titled ‘Risk Governance: Developing an Enterprise Risk Management Framework and Managing Emerging Risks, ranging from Climate Change to Cyber Threats’, O’Donnell draws on his long career in Canada’s financial services sector to highlight today’s most important risks.

He illustrates the growing risk of cyber security with examples of recent breaches in financial services.

The 2015 cyber attack on Japan Pension Services, a government-run agency that manages the public pension system, revealed the personal details of 1.25 million beneficiaries; JP Morgan fell victim to the largest theft of customer data ever in 2014 when hackers revealed personal information of 70 million households and 7 million small businesses; in February this year a cyber attack that investigators have linked to hackers in North Korea drained $81 million from the Central Bank of Bangladesh.

Moreover, it is a risk that is set to escalate with the rise of quantum computing. As computing grows faster and stronger, he believes it will render today’s cyber security “obsolete”, requiring a “quantum defence” to meet the massive increase in computer capacity.

Canada’s pension funds perceive cyber security as a “key risk” to “manage and take seriously”, and he urges the global industry to work as a group and share information to combat cyber crime. There is no benefit in working alone because hackers look for the weakest link, he says. “In Canada, we are all in it together.”

He says that recent cyber attacks should “plant the seed” for pension funds to think about their critical infrastructure risk, and ensure they have a cyber security framework in place.

He highlights the questions executives should ask: “Do we have a formal cyber security framework? What are the top five cyber risks we face? How are employees made aware and trained for their role? Are roles and responsibilities clear? Do we have a response protocol in the event of an attack?”

Climate risks growing

O’Donnell calls climate change “a very serious and significant risk of our time” and urges executives to understand the portfolio risk it holds.

He divides these risks into physical (physical damage to pension fund assets), regulatory (stranding and devaluing of carbon assets), systemic (broader shifts in the market place), and liability (the fiduciary responsibility to manage these risk and to rebalance to manage risk.)

He also draws attention to lessons that the pension industry can learn from the insurance industry.

“There are significant statistics from the insurance industry on physical risk like weather-related damage to buildings,” he says. “If I was a pension fund, I would wonder what this means for the assets I own. Do I have sufficient insurance in place and are my counterparties strong enough? Should I hold assets less susceptible to risk?”

O’Donnell’s third emerging risk is financial, caused by the growing asset bubble and “debt in the system” that has grown since the financial crisis. He notes that “exploding” global debt levels have risen from $150 trillion in 2007 to more than $200 trillion in 2015, and estimates that China’s debt has quadrupled since 2007 to $28 trillion.

It’s a problem that has been fuelled by low interest rates and quantitative easing, and now depends on policy from the US Federal Reserve to solve. “The real question is what will this mean when the next recession hits? If the next recession is steep and violent, how do firms start preparing for this today?” he asks.

In among today’s risk he also notes opportunity for investors in big data. The volume and variety of data coming out of financial firms and stored for analysis will increasingly inform strategy. Data scientists can analyse data to “look at what is happening in the economy”, understand cash flows and “do a better job” of credit analysis, he says.

Central risk culture

O’Donnell believes pension funds can manage risk if they build a strong link between their investment strategy and risk appetite.

A “central risk culture” should lie at the heart of an organisation, something he identifies as behaviour, values and systems: behaviour is characterised by actions of the CEO and values by how an organisation deals with challenges. Systems include a clear accountability of risk.

“Who owns the risk? Everyone should understand their roles and responsibilities. Risk appetite should be fully imbedded; it’s not just a glossy piece of paper but needs to permeate through organisation.”

He characterises risk appetite as the maximum risk an organisation is comfortable taking and risk capacity as the total amount of risk an organisation can take in light of its balance sheet.

“The weakness of risk culture caused the Great Financial Crisis,” he says, and adds that a “broken risk culture” is one that spirals into a blame culture, where difficulties and challenges are met with “pointing the finger.”